III Innovations and Institutional Changes in Major Financial Markets—A Ten-Year Perspective
- International Monetary Fund
- Published Date:
- January 1987
Trends in Financial Markets
Financial markets in major industrial countries during the past decade have expanded rapidly, outpacing the growth in nominal income in those countries. Coupled with this increase in activity, these financial markets have also undergone extensive structural changes. In this connection, five broad trends are described in this section: the growth in financial markets, the progressive internationalization of financial transactions, securitization and innovation, the liberalization of national financial markets, and the strengthening of the supervisory and regulatory framework that had existed in the mid-1970s.
During the decade 1976–86, real activity in the major financial markets has expanded at a more rapid rate than real output in the major industrial countries. For example, international bank lending (net of redepositing) and net international bond issuance measured in U.S. dollars and deflated by the U.S. GNP deflator grew 2½ times faster than real GNP in the industrial countries during 1976–86. The expansion of securities and equity markets has been evidenced by the sharp rise in the ratios of outstanding bonds to GNP and capitalization of equity markets to GNP (Tables 38 and 39). The expansion of securities and equity markets has exceeded that of money markets as indicated by the more modest increases, and indeed declines in two industrial countries, in the ratios of broad money to GNP.
During this period, the debt-to-income and asset-to-income ratios of the public, corporate, and household sectors have risen in most major countries (Table 40). The higher ratios of debt to income for the public sectors reflect the large-scale fiscal deficits that have persisted in most major countries in recent years. The higher private sector ratios of debt to income appear to be associated with a number of economic factors. For example, the tax deductibility of interest payments in some countries and the largely unanticipated increases in inflation of the late 1970s combined to reduce the real after-tax interest cost of borrowing. In addition, financial liberalization has been accompanied by the removal of many of the quantitative controls on the growth of bank lending, and financial innovations have opened up new borrowing opportunities and lowered intermediation costs.
The expansion of financial markets has been accompanied by major shifts in the flow of funds among sectors of the major countries. In all major countries, the household sector has remained the main source of savings for other sectors, although the size of this sector’s financial surplus relative to GNP fell in all countries between the mid-1970s and mid-1980s. Although the business sector has traditionally been a net user of credit, its share of total credit has declined relative to that received by governments. In the major industrial countries, including those that have an external savings surplus with the rest of the world, the government has become a net absorber of funds. In the United States, the foreign sector has switched from a net absorber of credit to a net supplier, whereas the opposite has occurred in the Federal Republic of Germany and in Japan.
The internationalization of financial markets has been reflected in the faster growth of offshore financial markets and greater foreign participation in domestic financial markets. Although domestic financial markets have expanded at a more rapid rate than GNP, the growth of financial activity in the offshore markets has been even more rapid than that in the domestic markets. Between 1975 and 1986, the stock of Eurocurrency banks’ loans increased at an annual real rate of about 14 percent to reach $3.2 trillion; whereas the outstanding stock of Eurocurrency bonds grew at an annual real rate of growth of nearly 21 percent to reach $618 billion. Although domestic bond issuances climbed sharply in a number of major countries as large fiscal deficits arose in both the mid-1970s and the early 1980s, Eurocurrency bond issues grew even more rapidly (Table 41). However, the recent liberalization of access to major domestic bond markets, as well as the removal of withholding taxes on foreign holdings of domestic securities, may have improved the competitive position of these markets relative to the Eurocurrency market (Table 42).
The growing importance of external financial transactions for domestic banks in the major industrial countries has been reflected in the rise in the proportion of total bank business accounted for by foreign loans or foreign security purchases. For example, the ratio of the external assets to total assets of banking institutions in France, the Federal Republic of Germany, Japan, Switzerland, the United Kingdom, and the United States rose from 14 percent at the end of 1975 to 19 percent at the end of 1985.
The greater participation of foreign financial entities in domestic markets has also been evident in most major markets. The number of foreign banking firms in the major industrial countries increased sharply and accounted for a considerably greater share of total bank assets (Table 43). The introduction of foreign securities firms into domestic markets also proceeded at a rapid pace. For example, several stock exchanges (e.g., in Japan and the United Kingdom) further expanded their membership in 1986 and 1987 to include foreign firms.
Securitization has occurred in tandem with the internationalization of financial activity. Securitization has involved a greater use of direct debt markets—in which the lender holds a tradable direct claim on the borrower, and a shift away from indirect finance—in which an intermediary holds a nontradable loan asset and the saver holds a liability (which may be tradable) of the intermediary. In particular, syndicated loans have been increasingly displaced by issues of international bonds or, more recently, by the use of note-issuance facilities or nonunderwritten Eurocommercial paper (Table 44). Although securitization has changed the form in which banking institutions provide credits, banks have remained an important source of credit.
In addition to the shift of credit flows from bank lending to securities markets, a second form of securitization has involved the packaging of assets that are normally not traded (e.g., bank loans, corporate receivables, and household liabilities) into tradable securities. This has been done either by using the original assets as collateral for a new tradable securities issue (collateralized obligation) or by issuing a new tradable security that is being serviced by the proceeds of the original assets (pass-through security). In addition, many lending instruments, which are technically not securitized, carry provisions allowing for their transfer to third parties (e.g., transferable loan certificates).
A third form of securitization has involved the creation of exchange-traded futures and options contracts. In this case, a certain type of risk, usually one associated with price volatility, is securitized. During 1986 and early 1987, several new contracts for financial futures and options were introduced on major exchanges and the turnover volume of existing contracts showed unprecedented increases. Several countries introduced new financial futures and options contracts, and trading volume increased significantly during 1986–87 (see Appendix II).
Yet a further aspect of the securitization of international financial markets has been the increased volume of secondary trading in various securities markets. For example, the primary issue of Eurobonds has grown since 1980 at an annual rate of about 45 percent, while secondary market trading has expanded by nearly 60 percent.
The liberalization of financial markets during the past decade has proceeded along four avenues: the liberalization of cross-border financial flows, the growing foreign participation in domestic markets, the introduction of new instruments, and the removal of domestic price and quantity restrictions. Prior to the gradual removal of capital controls in the major economies and restrictions on participation of foreign financial firms in domestic financial markets, a variety of legal and fiscal restrictions on international transactions had been used to control both capital inflows and capital outflows. By 1974, the United States had removed various administrative guidelines that may have inhibited foreign access to U.S. financial markets or curtailed foreign lending by U.S. financial institutions. (Foreign banks have had access to U.S. domestic markets on the basis of national treatment since the International Banking Act of 1978.) The U.S. authorities also abolished the withholding tax levied on nonresident holders of bonds issued by U.S. residents in 1984. The United Kingdom undertook a major step toward the liberalization of sterling cross-border transactions by removal of exchange controls in 1979. The controls were designed to prevent capital outflows and their removal, along with the lifting of lending restrictions on banks (the so-called corset), opened the sterling banking and securities markets to foreign borrowers.
The German authorities have also significantly reduced restrictions on capital inflows. In the 1970s, these restrictions were principally authorization requirements for nonresident purchases of domestic bonds and money market instruments and, for a few years, restrictions on payments of interest on bank deposits held by foreigners. Such restrictions were progressively removed in the 1970s. Access to German capital markets was further liberalized with the recent replacement of the calendar for issues in securities markets with a simple notification system, and with the removal of a 25 percent withholding tax on interest payments on domestic bonds to nonresidents; however, it has been proposed that effective January 1989, a 10 percent withholding tax be reimposed on interest payments on bonds issued by domestic entities in the Federal Republic of Germany.
In Japan, the authorities have, since the early 1980s, undertaken an extensive liberalization of cross-border financial activities. The set of foreign institutions allowed to issue in the Japanese securities markets has been gradually extended. In addition, the Euro-yen bond market was opened to foreign corporations in 1984, and access to this market was further extended to foreign banks in 1986.
French authorities during the mid-1980s undertook an extensive liberalization of cross-border financial flows. The Euro-French franc bond market was reopened and exempted from a 10 percent withholding tax applied in domestic markets, and foreign exchange repatriation and hedging restrictions were reduced.
The past decade—and particularly the last six to seven years—has also witnessed a significant expansion of the instruments used in international and domestic financial transactions. Many of these innovations originated in either the domestic U.S. market or in the Euro-dollar markets and then spread to domestic financial markets in other countries. The introduction of the floating rate note in the early 1970s was one of the first major innovations. Over time, the volume of international lending through this instrument grew to exceed the volume of lending through the syndicated loan market. The introduction in 1981 of note-issuance facilities—medium-term arrangements that allow borrowers to issue short-term notes in the Euromarkets backed by underwriting commitments of commercial banks—represented another important broadening of the choice of instruments. Currency and interest rate swaps—first undertaken in 1981 and amounting to over $500 billion by 1986—have been particularly significant.
The range of financial instruments available in domestic securities markets has also expanded. Innovations have generally occurred in financial instruments that compete mostly closely either with bank liabilities, such as mutual funds or short-term government bills, or with bank assets, such as commercial paper. In France, banks started issuing negotiable certificates of deposit in 1985. In addition, the government made short-term treasury securities available to nonbanks and banks. Also, to complement the domestic bond market, the financial authorities opened a financial futures market (MATIF).
In the Federal Republic of Germany, the range of new instruments was extended by granting permission for zero coupon bonds with debt-warrants, floating rate notes, certificates of deposit, dual currency bonds, and currency and interest rate swaps. In Japan, the liberalization effort centered on the creation of money market instruments as the authorities authorized negotiable certificates of deposit, removed restrictions on the interbank call and bill discount markets, and permitted repurchasing of bonds and certificates of deposit to grow. In the United Kingdom, commercial paper was introduced into domestic financial markets, and in the United States, the introduction of exchange-traded financial futures and options was noteworthy.
The structure of principal financial markets was also reformed. In the United States, the New York Stock Exchange was induced in 1975 to replace fixed with negotiated brokerage commissions, and the so-called shelf registration, which allowed borrowers in U.S. securities to register a proposed issue up to one year in advance of the issue day, was introduced in 1983 by the U.S. Securities and Exchange Commission, thus allowing for a flexible response to market conditions.
The U.K. authorities induced in 1986 the Stock Exchange to end a fixed schedule of brokerage commissions in favor of negotiated commissions. Stock exchange members are now permitted to deal directly with investors (i.e., to act as agents and principals). The gilt-edged market has been reorganized along the lines of the market for U.S. Government securities, that is, a system of primary dealers served by a number of interdealer brokers.
Supervision of financial markets has become more difficult as the various risks inherent in increasingly complex financial transactions—credit risk, liquidity risk, interest rate risk, and settlement risk—have become less transparent. Furthermore, the array of new instruments has made it more difficult to prevent financial firms from exploiting explicit or implicit guarantees (of liquidity and solvency) provided by financial authorities. The response has been to strengthen supervision of financial firms, and to encourage, via the mechanism of appropriate capital requirements, a pricing of on- and off-balance sheet activities of banks in accordance with their risk, and to seek greater convergence and coordination of supervisory and regulatory efforts among various national authorities.
The disturbances in 1974 surrounding the failures of Bankhaus I.D. Herstatt and Franklin National Bank led to the formation of the Committee on Banking Regulation and Supervisory Practices (the Cooke Committee), under the auspices of the BIS. The Committee’s main objective has been to try to establish comprehensive prudential practices including, notably, practices designed to ensure that banks’ foreign operations do not “escape supervision.” In December 1975, the Cooke Committee endorsed a concordat on international bank supervisory cooperation, indicating the division of supervisory responsibilities between parent and host country supervisors.
In 1978, the BIS Governors endorsed the Cooke Committee’s proposal that banks’ capital adequacy should be monitored on a consolidated basis, inclusive of foreign branches and of majority-owned subsidiaries, and, where possible, minority holdings and joint ventures.1 Nonetheless, events such as the problems of Banco Ambrosiano Holding in 1982 indicated that there were still gaps in the supervisory net.2 In 1983, a revised version of the concordat was published,3 which examined ways of avoiding gaps in supervision that may arise as a result of inadequately supervised centers or the existence of intermediate holding companies within banking groups.
Since the emergence of widespread debt-servicing difficulties among developing countries and weaknesses in certain sectors of industrial economies during recessions in the early 1980s, there has been a coordinated effort to strengthen banks’ balance sheets, reversing the downward trend in capital relative to assets that prevailed during the 1970s and early 1980s (Table 8).
|Germany, Fed. Rep. of5||3.3||3.3||3.3||3.3||3.3||3.3||3.4||3.5||3.6|
|Largest five banks||7.8||7.6||7.6||7.4||7.3||7.1||7.1||7.8||7.8|
|Largest four banks10||7.5||7.2||6.9||6.5||6.4||6.7||6.3||7.9||8.4|
|Nine money center banks12||4.7||4.5||4.5||4.6||4.9||5.4||6.2||6.8||7.3|
|Next 15 banks12||5.4||5.4||5.5||5.2||5.3||5.7||6.6||7.2||7.5|
|All country reporting banks12, 13||5.5||5.3||5.3||5.4||5.6||5.9||6.5||6.9||7.2|
Two principal supervisory techniques exist for assessing capital adequacy—a gearing ratio, which is the unweighted total of all on-balance sheet items divided by capital, or a risk-asset ratio, which is a risk-weighted total of on- and off-balance sheet items relative to capital. During this period, agreement was reached among supervisors on the advantages of the risk-asset approach, especially for coping with off-balance sheet risks. At the end of 1986, France, the Federal Republic of Germany, Switzerland, and the United Kingdom utilized a risk-asset approach; this approach was also applied to overseas activities of Japanese banks with foreign branches. U.S. Federal regulators circulated in 1986 a proposal for a risk-asset ratio approach.
In 1986 the Cooke Committee published a report4 that outlined a basic framework for supervisory reporting systems that sought to integrate on- and off-balance sheet risks. The main conclusion was that risks associated with most on- and off-balance sheet activities are not different in principle. The report proposed an integrated approach to assessing a bank’s risk exposure through procedures for translating various types of off-balance sheet instruments into their rough “equivalent” on-balance sheet credit risks.
The issuance in March 1987 of a joint United Kingdom-United States convergence proposal for monitoring capital adequacy marked a significant step toward a common supervisory framework for credit risk. In June 1987, Japanese authorities announced their willingness to participate positively in the efforts for the harmonization of banking supervision. A common supervisory framework for monitoring capital adequacy would significantly diminish the opportunities for regulatory arbitrage by banks among the three largest international financial centers.
Supervision of banking and securities markets in the United Kingdom underwent a major reform in 1986 with the passage of the Financial Services Act. Under that Act, which became effective in January 1987, the Secretary for Trade and Industry was empowered to regulate businesses that provide financial services. These powers were in turn delegated to a private body—the Securities and Investment Board (SIB), which recognized several self-regulatory organizations (SROs) covering activities in the securities and investment field. Financial institutions undertaking a range of financial market activities may report to several SROs. The gilt-edged market is regulated by the Stock Exchange and the Bank of England. Primary dealers and interdealer brokers are required to have dedicated pound sterling capital and to be members of the Stock Exchange, although prudential supervision is carried out by the Bank of England. Prudential supervision of deposit-taking institutions continues to be the responsibility of the Bank of England.
In the United States and Japan, banking and securities institutions are separated by law, as are prudential supervisory functions; whereas, in continental Europe, these business activities can be carried out within the same institution, and when that institution is a bank, it is subject to a common bank supervisory framework. The separation of supervisory regimes in the United States and Japan has been maintained even as the activities of banks and investment houses have tended to blur in these markets. In addition, international activities of subsidiaries of investment houses and minority-owned subsidiaries of banks have not yet been fully integrated into the supervisory framework of major industrial countries.
In Japan, securities companies are prescribed by a Cabinet Order to meet certain minimum capital standards. Those standards were in effect from 1963 to October 1980. During that period the scale of securities business grew dramatically, so that the Ministry of Finance circulated a release among securities companies in November 1980 indicating “a desirable size of capital” that was double the existing standard and urged them to meet the new standard within two to three years. The Securities Bureau of the Ministry of Finance supervises securities companies, including their financial position, and determines whether the security company has a sound financial and revenue basis to continue stable operations.
Forces Creating Change in Financial Markets
The extensive changes in financial instruments, financial institutions, and regulatory structures of the previous decade represent the competitive response of market participants (in both the private and public sectors) to a series of macroeconomic disturbances and technological advances and to the arbitrage opportunities created by differences in financial market conditions.5
In the early 1970s, the structure of the major financial markets across the larger industrial countries was quite diverse. Each nation’s financial markets developed largely independently of others, reflecting both economic factors and government policies. Moreover, capital and exchange controls on external financial transactions in France, Japan, and the United Kingdom discouraged financial integration. In this environment of relative macroeconomic stability and of incomplete cross-country linkages between financial markets, the structure of domestic financial institutions, and the attendant regulatory arrangements, primarily reflected domestic concerns. Nonetheless, the offshore (Eurocurrency) markets expanded rapidly, in response both to attempts to evade certain financial restrictions imposed by the authorities and to the need for international financial intermediary services.
Financial systems have been forced since the early 1970s to adapt to increased uncertainty about macro-economic conditions and to the need to finance large fiscal and current account imbalances in many countries. The greater uncertainty about macroeconomic conditions reflected the emergence of a series of historically large and unanticipated shocks to the international economy. The abandonment of the Bret-ton Woods system of fixed exchange rates was accompanied by a sharp expansion of cross-border financial flows and by the increased variability of nominal and real exchange rates—a factor that was to continue, albeit to varying degrees—throughout the floating rate period (Chart 11). Moreover, the uneven pattern of growth and recession in economic activity that was evident in the 1970s and 1980s may have further contributed to uncertainty about future developments (Table 9).
Chart 11.Monthly Averages of Daily Percentage Changes on U.S. Dollar/National Currency Exchange Rate Levels, July 1974–July 1987
Source: International Monetary Fund.
|(In billions of U.S. dollars)|
|Current account balances|
|Germany, Fed. Rep. of||…||…||…||1||1||5||10||4||4||4||9||–6||–16||–5||4||4||8||15||35|
|Oil exporting countries||–2||–2||–1||1||3||6||67||32||36||25||–1||57||104||50||–10||–22||–7||4||–32|
|Non-oil developing countries||–8||–8||–15||–16||–9||–6||–28||–38||–27||–23||–34||–50||–74||–98||–77||–42||–26||–27||–14|
|Countries with debt-servicing problems||–7||–7||–11||–12||–9||–6||–9||–24||–22||–23||–34||–35||–43||–72||–67||–23||–10||–6||–22|
|Real GNP growth|
|Oil exporting countries||9.1||12.4||11.8||10.0||11.1||10.8||5.9||5.9||8.3||6.9||1.4||2.4||–1.1||–1.3||0.1||–1.2||0.2||–0.4||0.9|
|Non-oil developing countries||4.5||7.6||7.2||6.0||4.9||7.1||5.0||4.7||4.2||6.0||6.1||4.8||4.6||2.5||2.1||2.5||5.4||4.5||5.0|
|Countries with debtservicing problems||6.6||6.5||4.7||6.8||6.9||7.9||6.7||3.3||5.7||5.3||4.1||6.1||6.1||0.1||–1.0||–2.8||3.6||3.5||4.4|
|Oil exporting countries||8.7||6.9||4.7||5.4||4.4||11.6||16.4||19.4||16.8||11.5||6.5||26.2||29.7||11.1||1.4||2.2||8.2||3.0||–5.8|
|Non-oil developing countries||5.3||52.9||6.5||7.3||9.1||15.3||21.5||20.7||23.2||22.1||21.1||25.7||30.0||27.5||31.9||40.8||49.1||52.8||35.0|
|Countries with debtservicing problems||11.7||10.3||11.6||13.6||18.6||27.9||34.9||47.2||66.5||49.7||42.5||47.6||57.0||57.1||67.6||105.8||134.0||151.3||84.3|
Inflation in the 1970s was higher and more variable than in the 1960s. The average rate of inflation in the industrial countries in the 1960s was 3.1 percent a year but rose to 7.9 percent in the 1970s before declining to 5.0 percent during 1980–86. The variance of inflation rates also increased from 0.6 percent in the 1960s to 6.7 percent in the 1970s, before declining to 5.5 percent in the 1980s. In the early 1980s, nominal and real interest rates also reached postwar peaks in most industrial countries and were more variable.
Taken together, these developments implied a fundamental adverse shift in the degree of macroeconomic instability in comparison with the late 1950s and 1960s. Since the instruments and financial arrangements in the major industrial countries were developed during periods of lower inflation and more stable conditions, immediate pressures were created for adapting instruments, institutions, and regulations. In addition, activity in international financial markets was sharply stimulated by sectoral imbalances that emerged as a result of the macroeconomic shocks. The recycling of the current account surpluses of the oil exporting countries associated with the oil price increase of 1973 and 1979 was accomplished primarily by private rather than public sector intermediaries. Most of the reserves accumulated by oil exporting countries as a result of current account surpluses were initially held as deposits in banks in offshore financial markets and in the major industrial countries. During the same period, lending from banks and other private creditors financed nearly half of the current account deficits of the non-oil developing countries.
In the early 1980s, sharp changes in access to these markets for many developing countries also had a major impact on the scale and distribution of credits through these markets. For countries with external payments difficulties, most additional credits from private financial markets were obtained through new money packages accompanied by Fund-supported adjustment programs. In contrast, flows between borrowers and lenders in the industrial countries accelerated sharply, with much of the growth being in the securities markets as opposed to bank lending.
The ability of financial institutions to adjust to these changes in macroeconomic conditions was influenced profoundly by technological advances in telecommunications and data processing. New developments in such areas as computer technology, computer software, and telecommunications permitted more rapid processing and transmission of information, completion of transactions, and less costly confirmation of payments. These advances by linking exchanges in different time zones made trading possible 24 hours a day. In addition, improved computer technology made possible new hedging instruments, including options and financial futures, whose initial pricing required the solution of complex mathematical and statistical problems.
While macroeconomic shocks, payments imbalances, and technological changes provided the principal stimulus for the rapid expansion of activity in international financial markets during the 1970s and 1980s, attempts to arbitrage financial conditions, including regulatory and institutional differences, often played a role in determining the scale and composition of the flows between particular markets. In addition, the authorities have placed greater reliance on measures to promote competition both within and across major markets as a means of obtaining greater efficiency—in the sense of reducing the cost of financial intermediary services—within financial systems. Competition has been enhanced by the weakening of capital controls and restrictions on the entry of foreign firms into domestic markets. In addition, most industrial countries have also undertaken extensive domestic financial liberalizations focused on either removing or weakening restrictions on interest rates that could be paid on the deposit liabilities of financial institutions, the use of instruments, and access to markets.
In the mid-1970s, interest rate ceilings were important constraints in France, Japan, and the United States but were not present in the Federal Republic of Germany or in the United Kingdom. These ceilings were progressively relaxed during the 1970s and 1980s. Pressure to relax these interest ceilings increased as savers sought higher market yields by purchasing government debt or money market funds. In addition, with the lifting of exchange controls, large borrowers and lenders turned to the Eurocurrency market to obtain additional funds and to earn a market return on their financial assets.
Restrictions on the activities, products, and location of financial institutions differed significantly between financial systems with universal banks and those with more segmented markets and activities. In the Federal Republic of Germany and in Switzerland, banks were allowed to undertake both commercial and investment banking activities, and they have extensive branch networks in their domestic economies. In contrast, commercial banks in the United States and Japan were more restricted, especially with respect to investment banking activities. In the United States, the Banking Act of 1933 (frequently referred to as the Glass-Steagall Act) prohibited commercial banks from underwriting either nonpublic bond issues or revenue bonds of state and local governments. In addition, under the Mc-Fadden Act of 1922, national banks in the United States could branch no further in a particular state than was allowed for the state-chartered banks. In a number of states, no branching was allowed. In Japan, commercial banking was formally separated after World War II from underwriting by Article 65 of the Japanese Securities Law. Japanese banks were legally permitted, however, to branch nationwide.
In some cases, restrictions on activities limited the ability of certain types of financial institutions to attain a diversified portfolio. This lack of diversification at times made these institutions vulnerable to geographic or sector-specific shocks. Where restrictions on activities or branching existed, some financial institutions attempted to undertake restricted operations in the Eurocurrency markets (unless prevented by capital controls) or through domestic operations under alternative corporate forms.
During the early and mid-1970s, the maintenance of extensive capital controls and limitations on entry of foreign financial institutions into the domestic market were part of the effort to isolate domestic financial systems from external developments. As noted earlier, France, Japan, and the United Kingdom had previously placed a variety of controls on capital flows, especially those involving short-term instruments. Entry of foreign institutions was sometimes restricted through controls on chartering and licensing, through restrictions on the activities that these institutions could undertake, and through constraints on their access to certain markets. There was nonetheless a movement toward a national treatment of foreign financial institutions (especially banks) under which these institutions became subject to the same regulations as comparable domestic institutions, although the number of foreign banks and their share of total assets varied from one key financial center to another.
The regulations and supervision of financial institutions were diverse and primarily focused on domestic activities of national institutions in the mid-1970s. In some cases, prudential regulations created incentives for institutions to adjust the location or types of their activities. Some financial institutions used off-balance sheet activities (e.g., guarantees or currency swaps) or operations in the external markets to minimize the costs of satisfying capital requirements. In particular, to the extent that the operations of branches or subsidiaries in the Eurocurrency markets were not consolidated, booking business offshore often reduced the effective level of capital needed for the firm as a whole.
Differences between the taxation of financial transactions and income from financial assets often led to a situation where financial transactions would take place (be “booked”) in a given market or country solely to reduce a tax liability. The withholding tax typically levied in domestic markets on payments of interest to foreign holders of domestic securities or deposits also stimulated the issuance of Eurobonds (not subject to any withholding tax) and the acquisition of Eurocurrency deposits. In addition, transfer taxes on security transactions (such as existed in the Federal Republic of Germany and Switzerland) discouraged the use of domestic money and capital market instruments and encouraged the use of external markets.
Accounting standards also differed significantly across the major countries. One key difference, for example, was associated with the extent of “hidden” reserves (typically associated with below market valuation of assets) in the accounts of financial and nonfinancial institutions. In countries such as the Federal Republic of Germany, Switzerland, and Japan, these reserves were more important than in other countries. Unreported charges against, and additions to, such reserves made it difficult to compare profit-and-loss statements across countries.
Differences in disclosure requirements reflected alternative philosophies about the types of borrower that should be allowed access to financial markets. One view was that market participants should be allowed to take on whatever risks (at a market-related price) that they desired so long as there was full disclosure of the relevant financial information about the borrower’s condition. The alternative view was that market access should be limited to more creditworthy borrowers (i.e., through merit regulation often imposed by the market); with the quality of the borrower being more assured, less detailed disclosure could be required. In the mid-1970s, the disclosure requirements established by the U.S. Securities and Exchange Commission (SEC) came closest to the first view. In contrast, borrowers in the Eurobond markets were traditionally limited to the more well-known firms, banks, and governments whose credit standing was considered sufficient. In line with the second view, that market, therefore, required less detailed disclosure, although to some degree additional disclosure existed when bonds were also issued in domestic markets.
The relaxation of restrictions on activities has enabled domestic financial institutions to compete more readily in nontraditional markets. This liberalization has helped foster more universal financial institutions, operating in a wider range of markets. While there are still important specialized or sector-specific financial institutions, the viability of these institutions increasingly depends on economic factors (e.g., market expertise and economies of scale) rather than official restrictions on entry or competition. In addition, there has emerged a broad range of financial instruments that has helped blur distinctions between market sectors. Nonetheless, financial institutions in some countries continue to face more significant domestic restrictions on certain of their activities (e.g., underwriting) than in the offshore or in other major markets. Moreover, accounting standards and disclosure requirements still remain quite diverse across the major markets. Different tax structures and contrasting legal arrangements also limit the arbitrage of differences in risk-adjusted yields across countries.
Implications for the International Economy
Changes in institutional structure, regulations, instruments, and supervisory practices are likely to continue. Although the pace of structural change in international markets in 1986 and 1987 slowed somewhat from that evident during the early 1980s, the major markets are continuing to become more closely integrated. The impetus for cross-border finance continues to be provided by macroeconomic developments and financial factors. Moreover, the further relaxation of controls on cross-border financial flows, the spread of new instruments and techniques, and the continuing effects of earlier innovations and deregulation measures provide new opportunities for cross-border lending and borrowing.
Continuing structural change in the financial markets carries important implications for macroeconomic policies and the international economy. These changes have affected the allocation of savings and investment among countries; the formulation and effectiveness of monetary, exchange rate, and fiscal policies; multilateral surveillance over exchange rate and other macro-economic policies (as well as the specification of appropriate indicators); the adequacy of international liquidity; the international coordination of financial supervisory and regulatory policies; and the stability of the international monetary system.
Resource Allocation, Market Access, and Market Stability
Throughout the 1970s and 1980s, international financial markets have played an important role in the cross-country intermediation of savings and investment, external payments, and fiscal imbalances. Access to financial markets, as well as the efficiency and stability of the financial institutions comprising these markets, has strongly influenced the scale and direction of the resource transfers that took place. Moreover, the institutional structure of international financial markets (e.g., the reliance on syndicated bank loans in the 1970s) and the portfolio preferences of borrowers and lenders influenced not only the composition and direction of capital flows but also the potential vulnerability of those flows to financial market disturbances.
During the 1980s, changes in access to international financial markets, financial innovations, and financial liberalization (along with other macroeconomic developments) exerted important effects on the distribution of savings and investment across countries. In the major domestic and offshore financial markets, those borrowers regarded as creditworthy were generally able to obtain credit at highly competitive terms. In contrast, developing countries that experienced debt-servicing problems in the 1980s lost spontaneous access to private financial markets and their recent financing requirements have been met largely by official flows, limited non-debt-creating flows (e.g., foreign direct investment), and new money packages accompanying Fund-supported adjustment programs. The difficulties of these developing countries in obtaining external finance stand in sharp contrast to the ability of some major industrial countries to obtain external financing. However, developing countries that are regarded as having a high credit standing have continued to have access to private financial markets and have been able to use new instruments in international securities markets.
To date, many of the structural changes in international financial markets have had mainly indirect effects on the developing countries with recent debt-servicing problems. For example, the efficiency of the foreign exchange reserve management practices of developing (as well as industrial) countries has been improved by the availability of new reserve assets, more competitive rates of return on these assets, and new hedging opportunities. Moreover, these countries have benefited from the innovations in instruments and financing techniques that have allowed multilateral development banks to reduce their borrowing costs, and to have a greater degree of access to portfolios. In addition, the payment of market-related yields on many types of deposit liabilities of the financial institutions in major countries, as well as the introduction of new types of investment instruments, may have increased the relative attractiveness of external assets for residents of developing countries.
The efficiency of the allocation of resources occurring through private financial markets depends upon the extent to which market prices adequately reflect the relative scarcity of capital in alternative uses, as well as the risks associated with these activities.6 If financial instruments are appropriately priced, then credit will be allocated in a productive manner. While the recent innovations in financial instruments and techniques in international financial markets have generally been viewed as increasing market efficiency—in the sense of lowering the cost of delivering financial services—concerns have nonetheless been expressed that they may also have adversely affected the stability of the financial system.
Some observers have argued that international markets may not properly allocate resources, because of incorrect pricing decisions by market participants, the presence of official guarantees and regulations, or macroeconomic factors (e.g., high and variable rates of inflation). For example, they have suggested that market participants sometimes are too shortsighted in evaluating and monitoring the liquidity and credit risks associated with new tradable instruments, because they assume that these instruments will be held for only a short period and could be sold before problems emerge. Liquidity risks arise when a borrower is unable to obtain the necessary funds to meet its obligations as they fall due. For example, banks have underwritten or provided backup facilities, and questions have been raised whether the pricing or the fees charged have reflected the underlying liquidity risks. Credit risks arise when a borrower is unable to meet its obligations in full. Margins on swap transactions have been viewed by some as providing limited compensation for the potential credit risks. Recent large trading losses have also suggested to some observers that financial institutions have not yet adequately managed the risks involved in the activities of their traders, and, at times, this has resulted in excessive price volatility.
It has also been argued that official regulations, guarantees (e.g., deposit insurance), and availability of a lender of last resort could influence the pricing of certain financial instruments. Moreover, higher variability (e.g., uncertainty) in macroeconomic developments may also make it difficult to evaluate the risks associated with holding particular financial instruments. A key unresolved issue has been the extent to which these factors actually distort market prices or whether “efficient” market prices prevail (i.e., those that reflect all the relevant current information, as well as the fundamental determinants of the demand and supply of credit).
These considerations raise the issue of whether the stability of liberalized financial markets is adequately ensured by the maintenance of appropriate macro-economic policies or whether other policy steps are required.7 The concerns about excessive risk taking and asset market volatility reflect a desire to avoid market disruptions that through contagion may result in the failure of otherwise solvent institutions. Moreover, with the growing international integration of major financial markets, a disturbance in one national financial market could quickly have implications for other national financial markets. Such disturbances could have their greatest potential for damage if they impeded the operation of the payments system.
The concerns about the overall stability of the financial system, including maintenance of the payments system and protection of depositors and investors, provide the basic rationale for macroprudential policies that include not only the central bank’s lender-of-last-resort function but also supervision of financial institutions. The changes in international financial markets have introduced new complexities into the provision of lender-of-last-resort services (or in some countries of public sector deposit insurance) and the international coordination of the supervision and regulation of financial institutions (discussed in the last section of this chapter). While no central bank provides a detailed description of the circumstances under which it will provide emergency liquidity assistance, the growing integration of financial markets, the expanded presence of foreign financial institutions in domestic markets, and the blurring of the distinctions between banks and other financial institutions have raised additional questions about which institutions or markets may have to be supported during a crisis period and by whom. Moreover, the extensive growth of international financial markets implies that the scale of emergency assistance needed (such as in the period surrounding the difficulties of the Continental Illinois Bank) could be significantly larger than in earlier periods.
One difficulty in providing emergency assistance is that knowledge of such potential assistance might encourage less prudent policies on the part of banks or other financial institutions, that is, the problem of moral hazard. In particular, troubled institutions could engage in high-return and high-risk activities in the hope of earning sufficient profits to avoid failure. Effective market discipline (through proper disclosure and reporting requirements) and prudential supervision are essential for preventing such situations.
Formulation and Effectiveness of Macroeconomic Policies
The growing integration of international financial markets has affected both the formulation and effectiveness of macroeconomic policies. Financial market interdependence has especially important implications both for the formulation of national monetary policy and for the coordination of such policies across countries. In the major industrial countries, financial liberalizations, the emergence of new financial instruments, and the removal of capital controls have affected both the linkages between traditional monetary policy instruments and the level of activity and prices in the domestic economy and the transmission of the effects of monetary policy across countries. The changes in financial structure may have made the timing, incidence, and ultimate impact of a given change in monetary policy more difficult to predict.
In the 1970s, the effectiveness of restrictive monetary policies in some countries at times relied on rationing the credit available to certain sectors of the economy (e.g., consumer credit and housing). This typically involved either direct limits on the expansion of bank credit or the presence of ceiling interest rates on deposits that resulted in withdrawals of deposits as market interest rates rose relative to the ceiling rates. However, the removal or weakening of interest rate ceilings and the availability of deposit liabilities bearing market-related interest rates helped stem such outflows of funds from depository institutions. Moreover, the removal or weakening of capital controls allowed many borrowers to have access to external financial markets as an alternative source of credit. The channels through which monetary policy affects the economy have thus tended to shift from those associated with limitations on the amount of credit toward those which relied on price (interest rate and exchange rate) adjustments. As a result, a higher interest rate may now be associated with a given degree of monetary restraint.
The growing integration of major financial markets also has been associated with increased sensitivity of capital flows to interest rate differentials and anticipated changes in exchange rates. For some countries, the exchange rate has thus become a relatively more important channel through which monetary policy effects are transmitted both to the domestic and world economies. In comparison with earlier periods, the growing responsiveness of capital flows and exchange rates to domestic policy actions implies that in these countries the effects of such actions tend to be felt relatively less on domestic activity and more on external variables (e.g., exchange rate and current and capital account flows). Within the domestic economy, it is therefore possible that the incidence of monetary policy has tended to shift principally from such sectors as housing and fixed investment (typically with an important share of nontraded goods) more toward the export- and import-competing (tradable goods) industries.
In addition to affecting the linkages between policy instruments and the domestic economy, innovations in financial instruments and techniques have affected the usefulness of individual monetary policy instruments. Reduced segmentation of domestic and international financial markets has sharply decreased the effectiveness of credit controls. In the absence of capital controls, many borrowers can readily substitute external sources of credit for any domestic sources that are restricted.
The adoption of new financial instruments and institutional changes in the financial system also have affected the information content of domestic monetary aggregates (e.g., as they relate to future changes in domestic output and prices) and have made control of the expansion of those aggregates more difficult.8 As new types of deposits and money market instruments have become available, the authorities in countries such as France, the United Kingdom, and the United States have often found it necessary to redefine relevant aggregates, in part in an attempt to retain a more stable statistical relationship between the aggregates, nominal income, and interest rates. In some countries, these difficulties have at times led the authorities to de-emphasize monetary targeting.
The income velocities of the key monetary aggregates in the major industrial countries have undergone substantial change and shown considerable variability in the period since the early 1970s, which has made it more difficult to gauge the timing and incidence of a change in monetary policy. A recent study of the velocity of principal monetary aggregates in the industrial countries reached three basic conclusions.9 First, velocities of narrow (i.e., M1) money aggregates have been more variable than those of broader aggregates. Second, Japan and the Federal Republic of Germany had the lowest variability of velocity over the 1974–85 period. Finally, for most aggregates, the variability levels were no greater during the 1982–85 period than during the previous subperiods—although this is generally seen as a period of accelerated financial change.10
The sharp changes in the velocities of narrow money have reflected the changing pattern of inflation (rising during the 1970s and falling during the 1980s), the growing availability of alternative types of liquid instruments carrying market-related yields, and the emergence of new cash-management techniques. There is also the issue of whether the financial liberalizations in the Federal Republic of Germany and Japan will adversely affect the relative stability of velocity relationships that have existed in the past owing, in part, to the greater availability of new money market and security market instruments. At least for the period through the end of 1986, those relationships have not deteriorated. Variability about a trend change in velocity cannot, however, be used as the only indicator of a deterioration, especially when the trend shifts.
As noted in the recent report by a study group of the Group of Ten central banks,11 the higher degree of capital mobility that has accompanied recent changes in international financial markets means that the effects of changes in domestic monetary policies are now likely to be transmitted more rapidly to other countries through movements in exchange rates, interest rates, and capital flows. In this environment, uncoordinated and conflicting macroeconomic policies may at times lead to rapid and sharp adjustments in interest rates and exchange rates as market participants recognize the incompatibility of the policy mix. Moreover, a given change in a domestic policy instrument is likely to have a more powerful impact on both the domestic and international economy when it is used in coordination with reinforcing policy changes in other countries. Such a greater impact would reflect not only the direct effect of a change in the instrument (e.g., a change in the discount rate) on portfolio and spending decisions but also the effect on private sector expectations that would arise from adopting a consistent and coordinated policy approach. Thus, the case for multilateral surveillance of monetary, exchange rate, and other macroeconomic policies has been enhanced by the developments in major financial markets. The growing integration of financial markets implies, however, that such surveillance may have to extend beyond a narrow focus on financial markets in just the major countries to also examine activity in the offshore markets.
The financing of fiscal deficits in the major industrial countries and the development of new financial instruments have been closely linked. In some cases, new money market instruments and liberalization measures were stimulated by the need to finance larger fiscal deficits. Treasuries have also been able to reduce their funding both by adopting new issuance techniques and new instruments. The greater ease with which fiscal imbalances can be financed has also allowed some countries to delay adjustments to underlying structural imbalances in their fiscal accounts. In addition, since foreign investors have come to play an increasingly larger role in the financing of fiscal imbalances, the impact of a given fiscal imbalance may be transmitted more rapidly to other countries.
Foreign Exchange Reserves, SDRs, and International Financial Markets
An adequate stock of international reserves allows countries to gradually adjust to unanticipated disturbances that may adversely affect or threaten to affect their international payments positions. Despite the shift to more flexible exchange rates, countries have continued to hold reserves as a precaution against unanticipated shocks, as a means of demonstrating creditworthiness, and for exchange market intervention. The relative stability of the ratio of non-gold reserves to imports for all countries together in the period since 1973 provides evidence of the existence of a stable long-term demand for international reserves.
The supply and distribution of reserves among countries and their consistency with the reserve needs of individual countries remain crucial issues for the international monetary system. Under current international monetary arrangements, many countries acquire reserves, in effect, by borrowing on international financial markets and hold reserves in highly liquid forms as short-term obligations of the reserve-currency countries and as short-term negotiable deposit liabilities of international money center banks. However, some countries with only limited access to financial markets have been able to acquire reserves only through balance of payments surpluses generated by the receipt of official financial flows, foreign direct investment, or by adjustments in current account positions.
For countries with access to international financial markets, borrowing from these markets has provided a flexible and efficient means of adjusting their gross reserve positions. The net cost of holding borrowed reserves—the difference between the cost of borrowed funds and the return earned on reserve assets—tends to be lowest for those countries regarded as the most creditworthy. Recent innovations in financial instruments have facilitated an improvement in the management of reserve assets, as well as in the funding of these assets. In particular, currency and interest futures and options have created some scope for countries to safeguard their assets against price movements in the short run, while the use of interest rate and currency swaps has reduced the net cost of reserve accumulation as well as allowed hedging against longer-term interest and exchange rate movements.
Even countries with ready access to international financial markets have found it nonetheless desirable to hold reserves in the form of liquid assets denominated in reserve currencies rather than to rely on their ability to obtain credit at a time of need. Access to financial markets and the cost of borrowing are determined by a country’s credit standing, which can deteriorate at the very time countries find it necessary to borrow, thus raising the cost of borrowing or causing access to be denied. Hence, under current monetary arrangements, the views of market participants regarding a country’s creditworthiness are an important factor in determining the availability and the cost of borrowed reserves.
Concerns have been raised that a reserve system heavily dependent on borrowed reserves may be vulnerable to financial market disturbances. In particular, such disturbances might make it difficult for some countries to maintain their existing stocks of borrowed reserves or obtain new reserves. Moreover, it has been suggested that such a system induces a potential deflationary effect on the world economy, because countries without access to financial markets act to produce current account positions that are large enough to service their external debt as well as to accumulate reserves.
Since borrowed reserves have played a key role in the current reserve system, the stability and efficiency of international financial markets, as well as the terms and conditions under which countries gain access to financial markets, are important considerations in evaluating the adequacy of the actual or potential stock of international reserves. In part, the potential role of the SDR in meeting the long-term global need for reserve supplementation would be influenced by whether international financial markets are likely to be an efficient and reliable source of borrowed reserves over time. In particular, SDR allocations could reduce the vulnerability of the reserve system to disturbances in financial markets by providing countries with a sufficient stock of owned reserves that would be available even during a crisis period.
Coordination of Supervisory and Regulatory Policy
The structural changes in financial markets have increased the importance of international coordination of supervisors and regulators. In particular, existing supervisory and regulatory structures may need to be modified to reflect not only recent structural changes in their domestic systems but also foreign financial systems. The ability of financial institutions to shift their operations across major domestic and offshore markets has also made it increasingly difficult for the authorities in a single country to undertake actions in isolation and has thereby increased the importance of the supervision of the consolidated accounts of financial institutions.
There is a diversity of views regarding the issue of whether the market and credit risks in newly liberalized financial markets have increased and what are the sources of any increased risks. Despite the diversity of views on the sources of market and credit risks in the system, there has developed a consensus that financial system stability requires, in part, some improvements in the capital positions of financial institutions. Moreover, it has been recognized that a common supervisory framework is needed to inhibit regulatory arbitrage and provide a “level playing field.”
There may also be a need to apply common standards to financial institutions carrying out similar activities within national markets, so that competitive inequities may be reduced and savings allocated more efficiently in response to underlying economic conditions. One difficulty associated with applying higher capital adequacy ratios (or restrictions on portfolio selections) is that they may encourage financial institutions to shift their operations to other markets (especially to those with lower capital adequacy ratios) or to use alternative corporate forms. As a result, the authorities have sought to implement regulations and supervisory techniques that support and strengthen best market practices.
The overlap in business interests between banks and securities houses and the integration of financial market activities have not been matched by developments in international coordination of the regulation of securities houses. Traditionally, the concern of securities markets regulators has been primarily with investor protection. The issue of credit risk management by securities houses has, however, become more important as they acquire such risks for significant periods of time through expanding underwriting and dealing activities.
Yet another tendency worth noting is the one toward larger, more diversified financial institutions with overlapping activities. So far, supervisors have concentrated on coordination of capital requirements in banking institutions, particularly in relation to assessment of credit risk. It is increasingly difficult, however, to judge financial institutions’ vulnerability to risk through an examination of individual institutions within financial conglomerates. Thus, there is a need for a broadening of supervisory examination that may reach beyond the issue of solvency of a single institution to consider such factors as the liquidity and interest rate risks facing the conglomerate as a whole.
These developments have also raised the question of whether supervision should be done on an institutional or functional (line-of-business) basis. While supervision in most countries has been focused on institutions, it has been argued that a functional approach may be more suitable in an environment in which firms take on a much larger set of activities (with different risks) than in the past. A difficulty with relying solely on functional supervision is that the risks associated with different types of activities undertaken by a given institution may be interdependent. The potential role of functional supervision is being explored by bank supervisors.
For a more detailed discussion of international coordination of bank supervision, see G.G. Johnson, with Richard K. Abrams, Aspects of the International Banking Safety Net, IMF Occasional Paper, No. 17 (Washington: International Monetary Fund, March 1983).
Since Banco Ambrosiano Holding was a bank-holding company—a 65 percent controlled subsidiary—and not a bank, under Luxembourg law, the Luxembourg authorities did not have supervisory powers. The Italian authorities felt limited responsibility for foreign subsidiaries whose activities they were unable to supervise. Subsequently, consolidated supervision was required by the Italian authorities of foreign banking and financial companies controlled, either directly or indirectly, through the possession of more than 50 percent of capital.
This document (“Principles for the Supervision of Banks’ Foreign Establishments”) was published in Appendix I of Richard Williams, Peter Heller, John Lipsky, and Donald Mathieson, International Capital Markets: Developments and Prospects, 1983, IMF Occasional Paper, No. 23 (Washington: International Monetary Fund, July 1983).
The Management of Banks’ Off-Balance Sheet Exposures: A Supervisory Perspective, Committee on Banking Regulations and Supervisory Practices (Basle, March 1986).
These factors were discussed in earlier surveys of international capital markets. See, for example, Maxwell Watson, Donald Mathieson, Russell Kincaid, and Eliot Kalter, International Capital Markets: Developments and Prospects, IMF Occasional Paper, No. 43 (Washington: International Monetary Fund, February 1986).
Two concepts of “efficiency” have at times been employed in evaluating the allocation of resources produced by financial markets. The most general concept (used above) involves the allocation of capital to activities that yield the highest risk-adjusted returns. An alternative concept (from capital market analysis) is that markets will efficiently allocate resources if market prices fully reflect all the relevant current information, as well as the fundamental determinants of supply and demand. In the absence of market distortions, these concepts would be in general technically identical; however, distortions (e.g., owing to official ceilings on some interest rates) might cause the two measures of efficiency to diverge. Unless noted, the more general concept of efficiency is used in this paper.
This is considered in Recent Innovations in International Banking (Basle: Bank for International Settlements, April 1986).
The information content of exchange rate movements would also be affected by official exchange market intervention. These problems have been discussed extensively in the Bank for International Settlements, Financial Innovation and Monetary Policy (Basle, 1984), and Organization for Economic Cooperation and Development, Trends in Banking in OECD Countries (Paris, 1985).
See Peter Isard and Liliana Rojas-Suarez, “Velocity of Money and the Practice of Monetary Targeting: Experience, Theory, and the Policy Debate,” Staff Studies for the World Economic Outlook (Washington: International Monetary Fund, July 1986), pp. 73–114. In this study, velocity is constructed by dividing the nominal level of GNP by the corresponding monetary aggregate. Variability is measured as the standard proportionate deviation of the sample observation around a simple trend line.
This conclusion holds even when the analysis is extended using data through 1986.
Recent Innovations in International Banking (Basle: Bank for International Settlements, April 1986), p. 249.